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CFTC launches broad investigation of energy and metals derivatives

Section: Daily Dispatches

Watchdog Probes 1 Million US Swap Contracts

By Greg Meyer and Kara Scannell
Financial Times, London
Monday, May 13, 2013

A top US financial regulator has launched a broad inquiry into the legitimacy of more than 1 million energy and metals transactions by the biggest traders in commodities markets over the past two years.

The Commodity Futures Trading Commission has issued a "special call" asking Wall Street banks and other traders to provide documents that would prove recent derivatives transactions known as "exchanges of futures for swaps" were legal. Lawyers at the CFTC enforcement division are also scrutinising the trades for possible violations.

"They are looking at a huge amount of trading," an industry lawyer said.

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The CFTC push shows how authorities are clamping down on previously unregulated derivatives dealing in markets from commodities to interest rates after the financial crisis. The CFTC this week is set to impose new trading rules for over-the-counter markets, even as the Group of 20 industrial countries seeks to shift more derivatives to electronic platforms.

The new inquiry centres on whether large traders and market makers used unregulated over-the-counter swaps markets to trade what were in fact futures, strictly regulated contracts that are economically identical to swaps.

Trading futures off an exchange is illegal, and regulators are concerned that traders may have used these deals, known as EFSs, to agree prices that did not reflect the market.

"They've made information requests to everybody that's ever traded an EFS. They're saying, 'Prove to us that the swap was legitimate,'" said a recipient of a CFTC document request.

Leading banks that have received document requests include JPMorgan Chase, Goldman Sachs, and Citigroup. The banks declined to comment.

EFSs are two-step transactions used by banks, oil companies, and hedge funds to arrange specialised commodities deals, often in illiquid markets where there are few counterparties and one trade could move prices dramatically.

In the first step, two traders enter a private swap contract linked to the direction of commodity prices. In the second step, an instant later, this position is converted into a futures contract as it is transferred to the CME Group clearing house.

CFTC staff are demanding information on EFSs executed following the passage of the Dodd-Frank financial reform law in 2010 until this year, people familiar with the inquiry said. They want traders to show the first step of the transactions involved swaps and not futures contracts masked as swaps.

One CFTC official said: "Where's the evidence? . . . It can't just be that a transaction is labelled a swap and there's no audit trail."

The CME clearing house has processed more than 1m EFSs and similar trades since 2010, according to the Futures Industry Association. Large traders said the transactions had not drawn objections from the CFTC previously. "It seems like a witch hunt," said one.

CME has provided traders with details of swaps transferred to its clearinghouse, but it is not clear this information will satisfy commission requirements.

Terry Duffy, CME executive chairman, said in a letter to CFTC last week: "In our view, nothing is served by piling on duplicative reporting mandates."

Any traders found to have misrepresented futures as swaps could face lawsuits and penalties from the agency. Last year Morgan Stanley was fined $5 million over what the CFTC called "fictitious sales" of futures.

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